Friday, October 10, 2014

Inflation that Isn't... Why?

Where's the inflation? Where's the run-up in bond rates?

Despite high debt, unsustainable long-term social spending, unfunded pension liabilities, and numerous other fiscal challenges, the U.S. bond market is strong and interest rates remain low.

Companies are facing increasing energy costs, unstable global situations, falling unemployment, rising minimum wages in larger cities, and a regulatory landscape that has shifted.

The Tea Party and the Occupy movements aren't exactly in the mood to reform corporate taxes, and the politicians reliant on both extremes aren't going to collaborate to improve the business climate in any meaningful way. (Yes, there are areas of agreement among most economists, across the political and theoretical spectrum, that good policy isn't good politics.)

If business costs and risks are rising, prices should be rising. With all levels of government fiscally unsound (and ungovernable), bond vigilantes should be circling. In theory, inflation should be creeping up with so many unfavorable variables. Yet, inflation is meaningless.

I discussed this situation with an economist from an investment firm, certainly no Keynesian, and I've also explored these questions with academic colleagues.

From my colleagues in business and academia, I've assembled a list of many theories on why there's neither bond inflation nor extreme consumer inflation.

Mild inflation is considered "good" in many ways by economists. Inflation devalues current debts, for example. This helps people and governments assume debt for socially beneficial investments. Governments selling bonds at a low interest rate to build roads that current receipts might not cover is something economists (generally) agree is sound policy. Inflation devalues the debt, making repayment a lower percentage of tax receipts. But, high inflation and rising bond rates make government invest risky, and debt repayment can ruin a government.

People want their houses, land, bank accounts, and wages to increase in perceived value. We could argue how real such increases are, and over the psychological value of inflation, but economists generally concur that our current global economies, two to four percent inflation is manageable.

And now, the theories on why there's minimal inflation:

1. Slack in the labor market. Yes, unemployment has fallen and 200,000 or so jobs have been created each month for almost two years, but underemployment and workforce participation rates indicate significant slack. Although skilled labor is tight, and wages are rising in places like North Dakota, overall there's little pressure to hire more people and pay higher wages.

2. Automation is working… in place of people. With emerging market factories opting for machines and software over once-cheap employees, the machines are rising. This allows companies to replace people or to avoid hiring new people. Some economists argue that since there are no mass layoffs, automation isn't hurting the economy. This is the same mistake made when considering higher wages: hiring deferred hurts economic growth, but it also reduces inflationary pressure.

Understand that automation and optimization are unavoidable. In nations with aging, shrinking populations, automation might be a great thing — allowing fewer young people to provide for their elders. But, automation that displaces workers or assumes roles of people never hired goes back to item 1.

3. Best of the worst economies. The United States and its various governments are among the best risks for investors. We're a safe haven in a world experiencing turmoil. This keeps U.S. bond rates low. Even a handful of large municipal bankruptcies didn't affect the muni bond market. If you want a safe, tax-free investment, bonds remain okay. Not great, but okay.

4. Generally benignly neglectful government. Our political system is in disarray, with gridlock at all levels. Yes, this creates some uncertainty, but not as much as some claim. As the business economist told me, no government action is at least predictable. Real uncertainty would be if we couldn't predict which party would have clear majorities in the House and Senate. Instead, we know that no majority will control the Senate, Republicans will control the House, and the President Obama has two more year. In other words… nothing significant is changing for at least two years and, barring a major electoral wave in 2016, gridlock is the norm.

Stability means companies have some certainty in the United States. Like being the best of the indebted economies, we're among the best of the worst governments. Not a point of pride, but it helps control inflation and bond vigilantes.

5. Domestic energy production. Energy, especially oil prices, affects inflation across product and service categories. How much domestic energy production, and increased energy efficiency, are counteracting other pressures is unclear, but these are helping control producer prices.

6. Frugal consumers, extravagant consumers. The consumer market is bifurcated, with the low-end consumers struggling. These consumers are keeping cars longer, buying fewer durable goods, and doing their best on flat or even declining salaries. These consumers, however, are masked by the steady consumption of the high-end consumers. Walmart shoppers become Dollar Store shoppers; Kroger gives way to Aldi. People are adjusting to lingering effects of the Great Recession… and that offsets inflationary pressures.

The economy grows, thanks to the high-end consumers. It grows slowly, though.

7. Weak housing market. The single-family, owner-occupied, mid-range housing market is weak. Housing demand being soft reduces inflationary pressures. Studies now show some people migrating from the pricier cities to lower-cost metro areas. House prices are rising, steadily, but demand limps along.

Other Theories

There are lots of theories on what happened and what's happening in the United States economy. Models failed to predict the Great Recession, and models haven't accurately predicted a recovery. Things are a mess, and might be a mess for many years to come.

I've read academic papers and institutional reports suggesting quantitative easing by the Federal Reserve, though potentially increasing inflation by devaluing the dollar, was absorbed by the equities market. The rich got richer, without any corresponding inflation. The access liquidity raised stock prices.

There is a theory that inflation is understated by the Consumer and Producer Price Indices. Prices of volatile food and energy being removed, and purchasing patterns changing among low-end consumers, leads to low official inflation rates, while the inflation in our daily lives is significant.

Whatever is happening, there will be consequences for fiscal mismanagement and political inaction. I doubt there will be hyper or even extreme inflation unless investors find a better place than the United States for their money.

The odds of that are pretty slim. Thankfully.

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